When is a Debt Consolidation Loan the best solution?

A debt consolidation loan is nothing more than getting a new loan to replace other loans or debts. Sometimes additional money can be borrowed at the same time to give you cash back, or for another purpose, such as buying a car.

Beware of claims which exaggerate the benefits.
Calculations of massive savings without a proper explanation of the assumptions and effects, are simply not credible.

A debt consolidation loan often has a higher higher interest rate, and is over a longer payment term than the existing loans which are being paid out.

And it is usually the longer term which gives the illusion of "savings" to the borrower, because the longer the term, the lower the periodic payments will be. But of course over the longer term, more is paid, and can become much more expensive.

The first to profit from any new loan are brokers and lenders. The more money they lend, and the longer you borrow it, the more profit they make. Whether you really benefit will depend on a number of things.

So when is a Debt Consolidation Loan Right For You?

Loan number 1 is for $5,000, repayable at $109 per month for 5 years, total payable $6,540 (12% interest rate)

Loan number 2 is for $150,000, repayable at $1,302 per month for 20 years, total payable $299,280 (8.5% interest rate)

So the total paid for the two loans after 20 years is $305,820.

Let say that the two loans are "consolidated", or added together, into one single loan of $155,000 which would be repayable at $1,247 per month for 30 years at an interest rate of 9%. The total repayable becomes $448,920.

The monthly repayments have FALLEN by $164 per month for the first 5 years, and then by $55 per month for the remaining 15 years. These are the magical "savings" made possible by the consolidation loan. ("Magical" because the reductions in payments are actually being lent to you, they are not savings at all.)

But the DOWNSIDE is that the total payable has INCREASED by a whopping $143,100, because the new loan is for 10 years longer, and at a higher interest rate.

Examples like this are not unusual, and can seriously erode your wealth and savings over time, and illustrating how the short term advantage of reduced monthly repayments can very quickly turn into an expensive mistake.

Sometimes the short-term cash flow savings provide a welcome relief. If cash flow is very tight, a debt consolidation loan can make things more manageable and help to relieve the financial stress.

That's why it is so important to prepare a budget before considering any re-financing proposal. It's only by doing this you can work out whether you a debt consolidation is the best option.

SUMMARY
Weigh up the pros and cons carefully, and consider all your options before getting a debt consolidation loan.

1. If a consolidation loan is used to replace higher interest debt (like a credit card), then it can definitely work to your advantage, as long as the term of the new loan is not so long as to cancel out the interest savings.

2. Reducing monthly loan payments can be a welcome relief if you are having trouble making ends meet. But this should be treated as a temprary solution, while you locate more long-lasting (and less expensive) alternatives.

3. Consolidating debt into your home loan (a common practice because of the lower interest rate) increases the risk to your home if things don't work out.

4. Lower payments on the new loan will be at the cost of more interest on a loan that goes for longer. This will erode your wealth and savings over time. It's the opposite of a retirement plan!

5. If a consolidation loan is recommended to relieve temporary financial pressure, use a budget to work out the best use of the money you save on repayments, so that the advantages don't just evaporate into higher lifestyle spending.

6. Before taking a consolidation loan, always look at the impact from both sides; take into account the long term cost overall, as well as the short term "saving" on repayments

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